When Companies Are Unfinanceable

In the context of raising capital for early stage or start up ventures, what it means to say that a company is “financeable” is generally well understood. Common factors include: the business model looks attractive from a revenue/profitability standpoint, the market opportunity is substantial and there is a strong management team. However, even when these factors are present, there can be others that can render a business unfinanceable.
These are aspects of a young venture that once disclosed or that should be disclosed to any reasonable investor, at a minimum devalue the venture or at worse become show stoppers. In our practice we run into ventures of this nature more often than we would like. This article briefly summarizes those factors that in our experience can prove problematic in this regard for a young venture and suggests ways of avoiding and removing these obstacles to funding.

Factors that render a venture unfinanceable can be classified into the following two general categories:

• Rights issues

• Founder issues

Rights Issues

Rights issues themselves can be broken down into two subcategories: intellectual property (IP) rights issues and contractual rights issues.

IP Issues

In the case of IP issues, the question comes down to whether the company’s IP is solely and exclusively owned by the company and is it locked down so as to prevent others from misappropriating it? Any right minded investor will not be interested in investing in a company that does not own and control the intellectual property necessary for its success. Yet somewhat surprisingly, many clients come to us without having taken the appropriate legal steps to secure their rights to their own technology. This might be analogized to a bank seeking deposits from customers even though it has an incomplete or flawed security system. Who would want to keep money in such a bank? Specific concerns in this regard include:

• Have the Founders all assigned their invention rights to the company in writing in exchange for their shares?

• Are there third parties who were involved in creating and developing the company’s product? If so, have they assigned their rights to the company in writing?

• Are there consultants or employees or former consultants and employees who either haven’t assigned their rights or are not under any obligation to protect company proprietary information?

• Are there third party IP rights that are critical or important to the company’s products or plans? If so, have those rights been appropriately secured and on terms that are commercially favorable?

Example:

• The ability of one client to raise capital or be sold was put into question while the company fought with one of its co-founders to get a formal assignment of a patent that he was a co-inventor of. The client neglected to obtain the assignment at the outset when the parties were on good terms.

Contractual Issues

In the case of contractual issues, the question comes down to whether the company may have inextricably bound itself into legal arrangements that are commercially unfavorable. The company may have attractive technology or plans, but investors will obviously shy away if it has committed itself to agreements that are one-sided in nature and effectively “give away the store.” Of particular, but not exclusive concern, are agreements that effectively provide the other party to the arrangement with unilateral control over markets, pricing and the profits associated with the company’s technology or products. Start up ventures that are short of capital and desperate for partnerships may be tempted to or naively enter into one-sided agreements of the following kind:

• Licenses

• Manufacturing Agreements

• Distribution Agreements

Any agreements of these types, if exclusive in nature and difficult or impossible to terminate can have the effect of mortgaging the company’s future – effectively shifting the value or potential value of the company to the other party to the arrangement.

Example:

• We once represented a company founded by an individual who had entered into a partnership with another individual prior to the founding. The partnership agreement had given the other partner exclusive marketing and sales rights to the founder’s technology. The partnership was eventually terminated unilaterally by the founder but without a clear accounting of the ownership interests. The partner made subsequent claims in excess of several million dollars and the founder refused to make a reasonable settlement offer to resolve the matter, leaving the company with an unresolved disclosure issue.

Founder Issues

Founder issues can be just as serious as rights issues and often these two sets of issues bleed into each other. The following are some of the kinds of founder or partnership issues that we run into:

• Uncertainty as to equity allocation

• Substantial founder loans

Uncertainty as to Equity Allocation

Ventures should and need to agree promptly on founding and as they move forward on who owns what shares, and this should then be clearly and promptly documented. Oral and/or vague promises to grant equity for services, particularly for percentages of the company, can create troublesome ambiguity months or years later as to the legal ownership of the company. Careful consideration should be given as to whether any specific share grants should be subject to appropriate vesting conditions, as the failure to implement these kinds of arrangements can lead to dysfunctional ownership – shareholders with disproportionately large share ownership who are no longer working at the company can adversely affect the ability of the company to reward those who are actually propelling the company forward.

Examples:

• We currently represent a company that operated a few years without counsel for financial reasons. By the time we were engaged the stock records were in disarray. Fortunately and to the credit of the share and debt holders (numbering in excess of 20), each one of them cooperated with the founders and the company’s counsel to resolve by agreement all issues related to capitalization, allowing the company eventually to raise several million dollars in venture money.

• Four individuals, whose collective venture had already achieved certain sales and orders for its product, came to our firm with the objective of incorporating and raising capital. When the time came to issue the founding shares, a dispute arose as to an agreeable allocation, including whether or not to subject all or some of the shares to vesting. For months, the founders could not agree on the right formula. Frustrated with the lack of progress, a key member of the founding team left, effectively killing the company and its plans. (See also “The Art of Allocating Founder’s Equity”)

Substantial Founder Loans

We see many ventures which have been self-funded by substantial founder or shareholder loans. Regardless of the merits of this method of funding from a dilution perspective, an outside investor will be extremely reluctant to step into the picture if the use of its new capital is used – not to drive the company forward – but to repay the founder.

Example:

• We were engaged by a nutraceutical company that had been funded by close to $1 million of shareholder loans to assist it with a $1.5 million angel financing. The order of magnitude of this debt created obstacles to the financing and we and an advisor to the company were able to convince the shareholders to convert a substantial portion of their loans into equity to facilitate the financing. We are advising a more recent client in the health and beauty space on how to address similar concerns.

Conclusion

In many cases, the obstacles to financing described in this article can be resolved after the fact and our firm has successfully assisted innumerable clients in this regard. Appropriate IP assignments and employee confidentiality and invention assignment agreements are put into place. Flawed agreements with partners and third parties are modified or terminated. Uncertain promises for stock are documented in writing and made certain; and shareholder and founder loans are converted into common stock or rolled up into long term promissory notes. All of this fits in with the understandable desire and habit of young ventures to economize on legal fees at the beginning of the venture when cash is short. At a minimum, however, aggravation and costs can mushroom if on the eve of a financing an ex-employee is no longer willing to cooperate or worse is competing; if a poorly negotiated license agreement gives away exclusive perpetual rights to substantial markets and the licensee is pleased with that arrangement; or if the allocation of founder’s shares was done on a napkin and one or more of the persons named are no longer involved in the venture. The essential point of this article is that in certain cases these kinds of problems cannot always be easily cured after the fact. It is therefore critical that entrepreneurs focus their attention on these areas as they arise and not let them potentially fester, lest they suffer the consequences when it comes time to raise capital or sell.

The information contained in this article should not be construed as legal advice or legal opinions on specific matters. The enclosed material is provided for educational and informational purposes by Chu, Ring & Hazel LLP as it may be of interest to clients and others impacted by the subject matter.